August 6, 2012

How the Knight Algo-Glitch Might Impact You

On Friday, SEC Chair Schapiro issued this statement about Knight Capital Group’s trading error, which is prompting the agency into conducting roundtables and investigations and hastening the SEC’s efforts into proposing rules that would require exchanges and other market centers to have specific programs in place to ensure the capacity and integrity of their systems. This in the wake of many retail investors giving up on playing the market – leaving machines to trade with each other in a high frequency trading world.

In our “Q&A Forum,” a member recently asked: “We are an NYSE issuer whose specialist is Knight & Co. whom you have undoubtedly heard on the news. We are closely monitoring Knight’s performance relating to the trading of our stock. I understand that Knight & Co. manages about 15% of our stock on the NYSE. How might this debacle impact us?”

Robert Rapp of Calfee Halter responded:

As one of the handful of NYSE “Designated Market Makers” (DMMs), Knight is a major market participant with the responsibility, among others, to conduct both physical and completely automated auctions for several hundred NYSE listed stocks assigned to it, and to maintain an orderly market in those stock. As a DMM, Knight also constantly competes as a market participant using “algorithmic” quotes, in an entirely automated process.

These computerized processes based on trading algorithms can go awry. Thus, as Knight has reported, on Wednesday morning it accidentally unleashed millions of orders to buy and sell stocks based on rogue algorithmic quotes. Characterized as a software glitch, Knight incurred some $440 million in losses for itself in the process, and caused major price volatility in a large number of listed stocks This in turn immediately adversely impacted Knight’s capital base and threatened its ability to stay in business.

As the extraordinary volatility in some stocks was happening, incoming orders were directed away from Knight. Also during that period existing mechanisms to curb volatility in single stock prices were triggered to a limited extent, resulting in trading pauses for some of the affected stocks. Once stability returned, transactions by other market participants occurring at the artificial prices were canceled by the exchanges. Because of the sudden and significant impact on Knight’s capital base, the issue now is the ability of Knight to continue in its role not only as a New York Stock Exchange DMM, but also as a major wholesale market maker generally.

As reported, Knight is actively engaged in efforts to shore up its capital base. If Knight were unable to remain a DMM, the stocks assigned to it would be allocated to other DMMs, and trading would continue as before, with another DMM having the same responsibility, commitments, and accountability in the market. However, because DMMs are active, competing market participants, and there are only a few of them, the quality of the market could be seen as diminished with the exit of a major player. The trepidation that has kept retail investors away in droves for some time would be amplified. Trading in individual listed securities, and price discovery, should not be impacted however, although as this most recent disruption reminds us, “algo” trading has fundamentally changed our stock markets. New “limit up-limit down” measures to curb volatility have been approved and are to be implemented on a pilot program basis effective February 4, 2013.

Hedge Funds & General Solicitation: The Brewing Controversy Over the SEC’s Rulemaking Plans

As I blogged recently, the SEC has noticed an open Commission meeting for August 22nd to consider three rulemakings. As noted in this Institutional Investor article, it appears that the SEC may adopt an Interim Final Rule on that date rather than go through the normal proposal and comment period. As reflected in this Investment Company Institute letter to the SEC, there are some that are not happy about this fast-track approach to an important rulemaking…

More on “The Mentor Blog”

We continue to post new items daily on our blog – “The Mentor Blog” – for members. Members can sign up to get that blog pushed out to them via email whenever there is a new entry by simply inputting their email address on the left side of that blog. Here are some of the latest entries:

– The Endangered Public Company
– Officer Removal: California Weighs In
– Delaware Expedites Proceedings to Enjoin Enforcement of Advance Notice Bylaw
– SEC’s Internal Controls Still Deficient
– Federal Judge Identifies Three Statement Categories That Are Not Actionable Under Securities Laws

– Broc Romanek